Friday, May 07, 2010

Pilgrimage to Omaha, Part 1: Defending the Carny

“There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business....”

Quick! Name the public company CEO who wrote those words in late 2008.

More specifically, you know Buffett’s 2008 letter to shareholders, which he wrote less than a year after the now-infamous ABACUS transaction—which Goldman Sachs & Company had helped assemble for the benefit of John Paulson—went (as we say on Wall Street) “tapioca.”

The “Oracle of Omaha” used his annual letter that year to explain why he expected the folks running Berkshire’s extensive utility businesses to behave well “in respect to all aspects of the business.”

Here’s the full version of that discussion:

Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises…

In the regulated utility field there are no large family-owned businesses. Here, Berkshire hopes to be the “buyer of choice” of regulators. It is they, rather than selling shareholders, who judge the fitness of purchasers when transactions are proposed.

There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business…

—Warren E. Buffett, 2008 Chairman’s Letter.

So, one might ask Buffett, how does he think Goldman Sachs & Company “behaved in respect to all aspects of the business” when it comes to the ABACUS transaction?

After all, a regulator is a regulator.

So it seems unlikely that a person, especially one who goes out of his way to judge behavior in terms of strict moral clarity as Buffett himself frequently does, could find a meritorious distinction between, on the one hand, the regulators of public brokers in power and light, and, on the other hand, the regulators of brokers in stocks and bonds.

Yet that, it seems, is precisely what Warren Buffett did when he rose to the benefit of the folks at Goldman Sachs & Company—at length and with slides to back up his words during last Saturday’s Berkshire Hathaway meeting—in their run-in with the SEC, which happens to be the most important regulator in the world of purveyors in stocks and bonds.

Now, for the record, we here at NotMakingThisUp expressed the view (in “From BACCHUS to ABACUS: Exhibit A in Defense of Goldman Sachs”) that while we hold no particular esteem for the moral DNA within Goldman Sachs, from our reading of the claim, the SEC doesn’t seem to have a leg to stand on:

1) By withholding the name of the seller—John Paulson—from the buyer, it seems to us that Goldman was doing nothing more or less than is expected of any broker in any securities transaction;

2) Far from duping a rank minor-leaguer, as claimed by the SEC, Goldman’s buyer was a German bank that had boasted of its major league prowess in the kind of complex instruments it eventually volunteered to purchase through Goldman Sachs & Company.

Many good readers disagreed with us, for many good reasons—particularly the ethical sliminess of a broker seeking a buyer for a cynically-constructed synthetic transaction designed to fail.

But people don’t go to jail for bad ethics, they go to jail for breaking laws, and while the ABACUS deal was quite slimy, it seemed no worse than much else we have seen from Goldman over the years. Thus, although we are not attorneys, and really don’t care what happens to Goldman Sachs & Company, the ABACUS deal seemed far from illegal.

Carol Loomis, the ace Fortune editor, asks the Goldman question right at the start of the session. And while Loomis is best friends with Buffett, we give her credit for asking some of the most controversial and difficult questions at the shareholder meeting for two years running—no easy thing with 17,000 Buffett acolytes in a Madison Square Garden-sized arena where Warren Buffett and Charlie Munger will be holding forth for five-plus hours.

Loomis launches straight into “Topic A,” as she calls it:

“Warren, every year you use the Salomon clip”—the video of Buffett telling Congress during the 1991 Salomon Brothers hearing that he had advised Salomon employees 'lose money and I will be understanding; lose one shred of our reputation and I will be ruthless'—which Buffett includes in the movie shown prior to the start of every shareholder meeting.

“Clearly Goldman has lost reputation because of the SEC’s action,” Loomis continues, and asks for Buffett’s “reaction to the lawsuit, your reflections, and what advice you would give the Goldman Sachs board.”

Buffett is ready. “Let’s start with the transaction,” he says, and begins what we will soon learn is an extremely well planned defense:

“A few weeks ago a transaction described as ABACUS, subject of SEC complaint—I think it ran 22 pages…” (A note: Warren Buffett knows numbers, so when Buffett says of the complaint, “I think it ran 22 pages,” you can bet it ran exactly 22 pages. It did.)

“I think there’s been misreporting—not intentional of course,” Buffett says of the brew-ha-ha surrounding the ABACUS deal, “I would like to go through that transaction first, then we’ll go through the questions.”

And go through it he does.

“The transaction, there were four losers…Goldman Sachs was a loser, they didn’t intend to be I’m sure, they kept a piece and they loss $90 or $100 thousand”—and while Buffett knows numbers, he did say ‘thousand,’ not ‘million,’ which is an odd mistake for a guy who really keeps track of money.

“… The main loser was a very large bank named ABN Amro which became part of RBS. Why did they lose money? They lost money because they guaranteed credit of another company.… They guaranteed the credit of another party.

“We do it all the time. Berkshire has made a lot of money guaranteeing these over the years. We lost money—years ago—on syndicates of Lloyd’s of all things, who found ways not to pay when they found our name on the thing.”

Buffett is teeing up his answer, demonstrating the broad working knowledge he possesses, while also making the point that there was nothing particularly unusual about the deal, except that the players were, by and large, sloppy:

“ABN…took on a $900 million of risk, and they got paid $1.6 million. The company they guaranteed went broke… It’s very hard to get upset about that.”

So far, so good. ‘What kind of moron guarantees $900 million in return for a lousy $1.6 million premium?’ Buffett is asking, before answering it himself: ‘ABN Amro, that’s who.’

Buffett then gets to ACA, the most visible party in the transaction:

“ACA was a bond insurer…they started out as a municipal bond insurer…all those companies started out insuring municipal bonds…and there was a big business and then the profit margins started getting squeezed….and what did they do? They got involved in other deals.”

Demonstrating his age and his 50’s-era sense of humor, Buffett repeats a hoary old joke he has employed many times over the years, in a variety of situations:

“I described this in the annual report a few years ago…like Mae West said, ‘I was Snow White but I drifted.’”

There is a bit of laughter, but clearly not all that many people know who Mae West is any more.

(The 50-for-1 stock split not only attracted a larger crowd of investors this year—20% bigger than 2009, we’d guess—but a younger crowd. At the Borsheim’s open house on Friday night, the crowd was much rowdier than in years past, and the number of Bud drinkers—as opposed to white wine drinkers—was distinctly higher. Still, what matters most to Warren Buffett is they were buying: every counter at Borsheim’s had customers looking over some piece of jewelry.)

Buffett concludes his point about municipal bond insurers like ACA that moved outside their field of expertise this way:

“They all did it and they all got into trouble, every one of ‘em.”

He then brings it back to Berkshire Hathaway:

“Now interestingly enough Berkshire went into the bond insurance business when these guys got into trouble,” although, he makes sure to emphasize, “we stayed away from things we didn’t understand…never insured a CDO.

“I wanna give you an example of something we did insure…if the projectionist would put up slide number one.”

Aha! Buffett has—as he has done in the past—prepared slides to support a point he knows he will be making sometime during the meeting.

The first slide of the day shows a list of $8.3 billion worth of state bonds broken down by state, including the likes of Florida, Illinois, Delaware and Utah:

“Somebody came to us a couple years ago…a large investment bank and they said take a look at this portfolio… They said to us, ‘Will you insure that these bonds in these states will pay for 10 years?’

“I looked at the list and Ajit Jain [Buffett’s ace reinsurance exec] looked at the list and we had to decide would we insure them and what premium we would charge. We offered to charge $160 million for 10 years… We will pay somebody on the other side—the counterparty they call it—if these states don’t pay, we will pay as if they did pay.

“We didn’t dream up this list,” Buffett says, and then makes one of the most revealing statements of the session.

“Another carny dreamed up this list.”

Who was the “carny” in this particular case? “It was Lehman Brothers,” Buffett reveals.

He then names several different reasons why Lehman may have been seeking insurance on the bonds, but adds flatly,

“We don’t care which scenario…if they told me Ben Bernanke was on the other side of the trade, it wouldn’t make a difference to me. It shouldn’t matter…we did with these bonds exactly what ACA should have done with these bonds.

“ACA said there’s about 50 we’d be willing to insure and then got another 30 more… We didn’t do that, we could have, but it was a totally submitted list.”

Buffett then brings it back to ABACUS:

“Now in the end the bonds in the ABACAUS transaction all went south very quickly…. It wasn’t that apparent at the time… Now there could be trouble in the states we insured, there could be big pension liabilities…but I seeing nothing whatsoever, I mean if I lose money on these bonds I’m not gonna go to the other side.

“I think the central part of the argument is that Paulson knew more than the bond people…they just made what in retrospect turned out to be a dumb insurance decision. Let’s say we had decided to short the housing market in early 2007 I don’t think anybody should blame us.”

Thus, Warren Buffett says that nobody should blame John Paulson or, by inference, the broker who packaged and sold the ABACUS transaction.

Take notice, however, of what Buffett just called Lehman Brothers: he called them “another carny.”

Thus, in Warren Buffett’s eyes, Lehman Brothers is a mere carnival barker hawking rigged games to tempt cash out of unsuspecting bystanders.

So how is this different from Goldman Sachs & Company?

Well that is the very question Loomis wants answered: she now prompts Buffett to move from the transaction itself to the question of how the SEC investigation makes him feel about Berkshire’s investment in Goldman, and its reputation.

The first part of the follow-up gives Buffett a chance to play the amusingly-greedy capitalist to the friendly crowd:

“Goldman pays us $500mm a year… $15 a second. Tick, tick, tick, that’s $15 a second…I don’t want those ticks to go away…they pay me at night, on weekends… We love the investment.”

This draws laughter and allows Buffett to move on to what might be the touchiest part of the issue, Goldman’s reputation, with a reservoir of good feelings on which to draw:

“Losing reputation—there’s no question the press of the last few weeks can hurt moral…it hurts…. I don’t believe the allegation belongs in the category of losing reputation…”

Hmmm... Let’s go back to Buffett’s own words from that 2008 letter to shareholders:

“There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business....”

Does Warren Buffett really hold his own utility companies to a higher standard of “behavior” than his friends at Goldman Sachs?

Consider it this way: if, at the behest of one of its customers, a Berkshire natural gas pipeline were to contract for a lousy batch of natural gas in order to sell it to another Berkshire natural gas pipeline customer, would Buffett defend that behavior?

The answer, of course, is no.

And in that light, it seems that the most rational—and successful—investor of his times has merely rationalized the behavior of yet “another carny.”

And he has done so for the sake of, oh, $15 per second.

This becomes clearer when Buffett asks Charlie Munger—his longtime sounding board, nicknamed “The Abominable No-Man” by Buffett for his deeply skeptical view of most deals (even deals that get the “Oracle of Omaha” temporarily excited)—what he thinks of the Goldman deal.

Munger, who happens to be an attorney and founder of a highly successful West Coast law firm in addition to being half of the most successful investment team in modern history, will agree with his partner in the strictly legal sense, but it becomes clear he has a different sense of the ethics of the thing....

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

15 comments:

Al
said...

The utility analogy doesn't seem appropriate given that a natural gas seller represents its product as adhering to a standard. As I understand GS's position, they create a market without any implied presumption as to the quality of the product.

My difficulty in understanding the ethical quandary rests in the apparent informational symmetry of the deal. All the parties, including Paulson, held independent opinions on the same information. In a more exuberant age, Goldman Sachs might have been called presumptuous for imposing its view on a market making operation.

Your book touched on this... But I try to make it explicit there: Basically we can't trust what Buffett says because he tells lies.

For example, Buffett said: if you were going to short someone’s future, how would you make that choice? It wouldn’t necessarily be the one with the worst grades or poorest test results… you’d likely pick the person whose attributes were most unattractive – the one with the oversized ego, lack of integrity, disregard for ethics or others’ feelings, the non-team player.

Well, buy endorsing Goldman and Moody's, he went long and strong on the very people that he tells everyone else to short. Buffett lies.

If one can't trust what he said, then why is everyone hanging on to every word he says? Because they are blind by outcome bias. Let's take a step back - imagine Buffett is poor, would anyone still care about what he says? Would his investment advice still make so much sense? Probably not. Does Buffett have skills, yes. Is he rich because of his skills or luck? Probably both. Since (a) we can't separate luck from skill in the investment business, (b) buffett lies, we can't rule out the possibility that Buffett is just lucky.

The fact that Buffett is incredibly rich somehow made him incredibly credible even though he lies (a lot). And that is wrong.

This shareholder meeting was noticeably different than the last one I attended seven years ago. The “cocktail” party at Borsheim’s the night before gave me flash backs of Summerfest (a spectacular 10 day music/drink fest along the shore of Lake Michigan in Milwaukee). Your correct on the beer/white wine ratio - they ran out of Bud Light. While I agree with your take on Buffet’s rationalization of Goldman Sachs I would not have expected him to say anything different considering the sizeable stake he has in the company. I did find it somewhat disingenuous to say Goldman lost money on the Abacus deal; did the risk management guys forget to “hedge” this risk. Moreover, this is not the first time he has held a sizable stake in a business where the reputation/ethics has been questionable (e.g. Solomon Brothers and Moodys). What I would like to know is who dropped out of the CIO race, who was added, and what manager did over 200% in 2009 without any leverage? Doesn’t sound like your typical ‘Buffet’ type investor – high quality businesses, strong balance sheets, sustainable competitive advantages, etc… - or is he/she more like the ‘Buffet before Berkshire” investor?

…..was it just me or were the “shareholder discount” prices at Borsheim’s equal to normal retail prices?

As Matthews has demonstrated in his writing, Buffett is all about one thing: making money. While he has crafted an image of himself as upholding the highest ethical standards, when ethics and making money conflict, clearly making money wins. Good business? Yes. Hypocrisy? Of course. But Buffett has always been primarily oriented toward profits, and the image he has created of himself is just another tool that has helped him along the way.

"To be honest, I don't know what Goldman does with all of their derivatives and whiz-bang trading gizmos, but I do know that Lloyd Blankfein is the best person to lead Goldman until he is indicted, at which point I will have a senior moment and forget we ever had this conversation. And if you don't believe me, you can ask Maurice "Hank" Greenberg, whoever he is."

Your Buffett-envy is showing again. Your constant attempts to show hypocrisy fall short, as does this attempt.You seem to be carrying a grudge against Buffett since he railed against the hedge fund industry and its fees.

Buffett is starting to remind me of Greenspan--an Old Gasbag, who craves the media limelight & defends the status quo.Young Buffet was an "outsider," an awkward boy from Omaha, who could pick overlooked under-valued stocks.

Al doesn't like the utility analogy. I see the point and it is a good one, but would argue that if Buffett didn't have a stake in GS he would not distinguish between GS's behavior in the ABACUS deal and that of Lehman's in the Berkshire muni deal--i.e. they both acted as "carnies."

Anonymous #1 raises an excellent standard--i.e. character--which Buffett has raised for many years, to the MBA classes in particular.

Powder Junkie refers to something Buffett mentioned in passing during the session and nobody followed up on, as well as something Charlie Munger talked about. We'll have more on this later in the series.

Anonymous #3 rehashes his old grudge match with this virtual column, adding nothing new in the process. As a student of Buffett--who owes his investment success to both his brains and his rational investment process--for 30 years, we always find it fascinating that investors don't use their own brains and look rationally at Buffett. Instead, they see either a perfect human being or a "an old gasbag," in the words of Anonymous #4.

Jeff - You said that people don't go to jail for bad ethics. However, people do get prosecuted for civil fraud for bad ethics. I think that you are are missing the single most essential aspect of the SEC complaint. If you are so sure that the SEC complaint is without merit, you should accept Barry Ritholz' bet. The fact that Goldman did not disclose the name of the counter party is nowhere necessary for the SEC to prove it's complaint. What Goldman was required to do was to disclose that some party existed which had some level of control of the contents of the CDO and which also had a material interest which was contrary to the interests of Goldman's customer.

Jon says I'm missing the essential aspect of the SEC complaint...that Goldman didn't disclose the "material interests" of the seller.

It makes no sense to me that Goldman needed to disclose the "material interests" of the seller: after all, aren't the "material interests" of the seller ALWAYS contrary to the buyer's "material interests"?

In other words, since when did buyers come to expect that the seller would leave money on the table for the buyer?

As for Barry's bet, I did offer to take it on the assumption that Goldman will have to settle without admitting to doing anything illegal, which, in Barry's way of thinking, is a loss for Goldman and he'd win the bet. So we agreed to disagree.

Perhaps I miss-stated, the relevant part of my comment should have said "substantial level of control of the contents of the CDO" not "some level of control of the contents of the CDO". On May 4, Felix Salman dismissed "Goldman not required to disclose identity of the seller" defense as a straw-man. Salman points out that the SEC provided an example of proper disclosure in the Magnetar disclosure; which nowhere discloses the identity of the seller.

When I first got into value investing, I worshipped him and thought he could do no wrong. Then I realized, most of what he does today is completely irrelevant to what I am doing. I could probably make more money following other investors.

At some point, I started to realize that just because he uses PG rated humour, doesn't make him a nice guy or some sort of demigod. It doesn't make him a bad guy either.

I guess I'm in the stage right now that he's not a genuine person. He's a politician. Helpful sometimes, ignorable much of the time. Most of the interviews with Becky Quick aren't real interviews and that CNBC Columbia Business School special was useless. The man rarely has to answer a serious question.

"As a student of Buffett--who owes his investment success to both his brains and his rational investment process--for 30 years, we always find it fascinating that investors don't use their own brains and look rationally at Buffett. Instead, they see either a perfect human being or a "an old gasbag," in the words of Anonymous #4."Gotcha, Jeff. Anyone who disagrees with you or has a strong opinion on Buffett one way or the other is therefore, irrational.

"It makes no sense to me that Goldman needed to disclose the "material interests" of the seller: after all, aren't the "material interests" of the seller ALWAYS contrary to the buyer's "material interests"?"

Are you telling us that a banana salesman's "material interests" are contrary to those of the banana buyer? It would appear to be so only if the fruit was rotten, but the buyer was unaware of it.